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Goldman Won't Let A Few Pesky Shareholders Stand In The Way Of Its Bonuses*

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In things that are not a surprise, a Delaware court this week threw out a lawsuit against Goldman Sachs directors and officers for paying bankers and traders The Wrong Way. Specifically:

The Plaintiffs contend that Goldman’s compensation structure created a divergence of interest between Goldman’s management and its stockholders. The Plaintiffs allege that because Goldman’s directors have consistently based compensation for the firm’s management on a percentage of net revenue, Goldman’s employees had a motivation to grow net revenue at any cost and without regard to risk.

The Plaintiffs allege that under this compensation structure, Goldman’s employees would attempt to maximize short-term profits, thus increasing their bonuses at the expense of stockholders’ interests. The Plaintiffs contend that Goldman’s employees would do this by engaging in highly risky trading practices and by over-leveraging the company’s assets. If these practices turned a profit, Goldman’s employees would receive a windfall; however, losses would fall on the stockholders.

Now, it should be said that this theory is not unprecedented, and not entirely crazy. Nor is it entirely sane: generally maximizing income is good for shareholders, and if you don’t like trading risk you could always, I don’t know, not buy shares of an investment bank. Linking comp to net revenue is broadly better than linking it to lots of other things, like peer-benchmark pay or fanciness of country club memberships.

But, yes, it encourages short-termism and risk. The solution – which the plaintiffs here apparently did not advance – is to require every employee of an investment bank to lock up 100% of his or her net worth in the equity (or super-equity) of that bank until the day that the employee dies, which would eliminate any conflict between short-term employee gains and the interest of semi-mythical long-term shareholders**, although it might make it harder for the bankers to pay for dry cleaning.

Anyway. The court wasn’t interested, since suing a Delaware company’s board for running its business wrong is really, really, really hard: under the business judgment rule, you need to more or less have good evidence not that the directors got it wrong but that they had no interest in getting it right:

Here, the Plaintiffs allege that the Director Defendants violated fiduciary duties in setting compensation levels and failing to oversee the risks created thereby. The facts pled in support of these allegations, however, if true, support only a conclusion that the directors made poor business decisions. Through the business judgment rule, Delaware law encourages corporate fiduciaries to attempt to increase stockholder wealth by engaging in those risks that, in their business judgment, are in the best interest of the corporation “without the debilitating fear that they will be held personally liable if the company experiences losses.” The Plaintiffs have failed to allege facts sufficient to demonstrate that the directors were unable to properly exercise this judgment in deciding whether to bring these claims.

Now, this standard should be contrasted with suing a Delaware company for doing pretty much anything M&A-related, where the bar is much lower. There’s a booming business in suing M&A targets because they didn't disclose that the sell-side banker, like, made photocopies at the buyer's office without paying for them. These cases generally settle for a moderately lucrative payoff to the plaintiff's lawyer.

The business of suing companies for overpaying their employees is less booming, on a law firm P&L basis, because those lawsuits never get anywhere. So why bring them? Well, the lead plaintiffs in this case are SEPTA (which will be familiar to Wharton students as the agency responsible for running Philadelphia's clever parody of a subway system) and the International Brotherhood of Electrical Workers Local 98 Pension Fund. These guys - they may not be exactly the paradigm of the long-term Goldman shareholder looking to maximize long-term value.

They may, in fact, be more interested in getting publicity for how eeeeevil Goldman is. You can get a sense of that by reading the court's opinion, which notes that one of their key arguments against Goldman's comp structure is - and here I'm paraphrasing - "Abacus! Levin report! conflicts of interest with clients!" This digging up of dirty laundry doesn't seem all that relevant to winning a lawsuit about pay practices, but it makes perfect sense if your main goal in suing is to get a little cheap press for the idea that "shareholders think that Goldman is some pretty poisonous calamari and are hopping mad about it."

Court of Chancery Dismisses Breach of Fiduciary Duty, Waste and Caremark Claims Challenging Goldman Sach’s Compensation Structure [Delaware Corporate & Commercial Litigation Blog]

In re The Goldman Sachs Group, Inc. Shareholder Litigation [pdf]

* Zero bonuses, maybe, but it's the principle of the thing.

** Actually, come to think of it, I am a (reluctant) long-term shareholder of Goldman, by virtue of some undelivered RSUs. So, full disclosure!